Europe: Three No's Revisited

The EU Summit will feature some growth measures, but little that will boost confidence that European officials will act to arrest the financial crisis. Even the road map to greater economic and monetary union appears to really be a road map of the road map. Concrete proposals may not be formally presented until the end of the year. Even the growth measures are less than meets the eye. It appears that most of the 120-130 bln euros agreed upon will come from freeing up unused funds. There is little of what used to be called "real water" when discussing Japan's pubic works spending. There are a number of observers who suggest Germany is isolated and in the face of overwhelming pressure, will capitulate. Bridgewater's Ray Dalio was quoted yesterday suggesting that a German bailout should not be taken for granted. We concur and tried to capture our understanding by suggesting that the European investment climate will be characterized by three no's: No ECB backstop for sovereigns. No joint bonds. No euro are break up. We would modify the "no joint bond" to mean any debt mutualization. This includes a euro area wide deposit guarantee, joint T-bills and a redemption fund. Germany is a creditor, and is defending its interests. Before the crisis, there were frequent references to Germany and France as the two pillars of Europe. The crisis has changed this. The new alignment is creditors and debtors. There are two immediate problems that arise. First, France's interests are more similar with those of the debtors. Second, from either the crisis or personnel (Merkel), Germany appears more willing to act in its political self interest than was the case previously. That said, France often butted heads with Germany to open its purse more and faster well before the crisis. Ironically, when France was the chief creditor and engine of growth in Europe, it made the same arguments that Germany is making now. After hitting a brick wall with pleas for the ECB to resume its bond buying program, and have been rebuffed on joint bonds, France and Italy have retreated to their back up position. Using the EFSF/ESM to support sovereign bonds of who Monti has called "virtuous" countries. The problem is that who decides who is virtuous. Is Spain virtuous? It is implementing various reforms. Yet consider that it has overshot its budget deficit target for a few years. In March, Rajoy unilaterally declared a new and higher deficit target than the one agreed with the EU and even the new deficit target is likely to be over shot. The Bank of Spain reported yesterday that the Jan-May central budget shortfall was 3.4% of GDP. The full year target is 3.5%. One of the first acts of the new French president was to lower the retirement age back to 60 (essentially protecting many of the older workers), while others in Europe are rising their retirement age. In a fiscal union, France would unlikely have been able to do this. It was following the election of Hollande, it appears, that Germany began talking (more earnestly?) about political union. Going back to Charlemagne, through Napoleon and the first half of the 20th century, there was a drive for the unification of the western peninsula of the Eurasian landmass. The original framers of the European Union understood two things: political union was the end game and integration grew by crisis. While the sovereign-bank link needs to be severed, the link between solvency and sovereignty needs to be strengthened. Essentially, countries that become insolvent lose their sovereignty commensurately,. It can be a question of degrees. The pressure on the debtors has to be great enough for them to cede sovereignty. What many have called "muddling through" is more than that. It is that incremental pressure on the debtors with no significant relief that leads to surrender. Rather than war being a continuation of politics by other means as Clausewitz would have it, it is through the crisis that Germany will strengthen its hegemonic position. It will create a union where the interests of the creditors are institutionalized. Previously, Europe was described as a German fist in a French glove. It turns out that the French glove is not strong enough. The Europe that emerges may be a German fist in a EU glove.